Credit Spreads Earn Income from Options with Limited Risk

1. Credit SpreadsEarn Income from Options with Limited Risk September 10, 2008 Robert Rubin

2. What Are Options? • Options give you the right to buy or sell a stock at a set price within a set time • The set price is the strike price • The set time ends on the expiration date • The option becomes worthless if not exercised by expiration • Calls give you the right to buy stock at the strike price • If a call’s strike price is below the market price, the call is worth the difference, plus the value of remaining time • If a call’s strike price is above the market price, the call is worth the value of remaining time • Puts give you the right to sell stock at the strike price • If a put’s strike price is above the market price, the put is worth the difference, plus the value of remaining time • If a put’s strike price is below the market price, the put is worth the value of remaining time • Options are traded • Option price affected by underlying stock price, time remaining to expiration, volatility, etc. • You can “write” your own options • Sell others the right to buy from you or sell to you

3. Credit Spreads • Two calls or two puts • Same expiration, different strikes • Write one (short), buy the other (long) • Short strike closer to the underlying stock – so higher premium • Hedged option sale – the opposite of a naked sale • Always starts with a credit • Short premium you receive, less the long premium you spend • You get the credit immediately • This credit is your maximum possible profit • Maximum possible loss is the difference between the two strikes, less the credit • Brokers require this much cash kept in your account as margin • You should never lose this much, with a good exit strategy • If the options expire, you keep the whole credit • If close before expiration, get original spread less closing spread

4. Bullish, Bearish, and Neutral Spreads • Bull Put Spread is two puts • Expect neutral or rising price for underlying stock, so sell puts • Bear Call Spread is two calls • Expect neutral or falling price for underlying stock, so sell calls • Iron Condor is a Bull Put Spread and a Bear Call Spread, both at the same time • Expect neutral price trend for underlying stock, so sell puts below and calls above • If short puts and short calls both expire, you keep the full double credit

5. Best Options for Credit Spreads • Adjacent strikes reduce risk • Smaller credit, but bigger hedge • Expiration in 2-6 weeks • Exploit time decay of options, fastest in last month • The spread shrinks as expiration nears, if all else unchanged • Just need short option to stay out of the money • Out of the Money options, as far out as possible • Then the trade works whether the underlying stock trends neutral or in the direction you expect – you can be wrong and still win • With In the Money options, the underlying stock must move in the direction you expect – bigger credits, much bigger risk

6. Best Options for Credit Spreads - 2 • Credit should be at least 10% of the Spread • Good reward/risk • Return on Investment is at least 10% for 2-6 weeks! • Options on indexes or broad high-volume ETFs • Unlikely to move much because a single stock blows up • Avoid risk of price gaps sinking the trade • Options with high Implied Volatility • IV measures the variability of prices • IV more sensitive to falling prices than rising prices • Short option with high IV more likely to fall in price – “volatility squeeze” • Get IV from your broker’s site, or from the CBOE - http://cboe.com/TradTool/IVolMain.aspx then click on IV Index

7. Implied Volatility at CBOE

8. Trend of the Underlying Stock • Bullish, Bearish, or Neutral for 2-6 weeks? • Leave yourself room to be wrong by picking the best options • Short options with strikes past key support or resistance prices • Reduce chance of going In the Money • Use Technical Analysis to find support/resistance and trend • EMA, MACD, Volumes, RSI, DMI, Price Channels, etc. • Identify economic and business issues driving prices • Use Fundamental Analysis

9. Credit Spread Calculators • Confirm profitability of a potential Credit Spread • Many free on Internet – • http://www.incometrader.com/csc.htm • http://avasaram.com/strategy/screener/verticalSpreadCalc.jsp • http://www.20method.com/tools.html

10. Credit Spread Calculator

11. Probability of Success • Estimate probable outcomes in advance of trade! • Look for about 80% minimum probability of success • Use a Monte Carlo Probability Calculator • http://www.volatilitytrading.net/monte_carlo_option_calculator.htm • Others can be bought • Assumes an unskewed normal distribution of prices • Risk greatest early in trade, before time decay works for you • Find the probability of hitting the short strike or key support/resistance prices

12. Monte Carlo Probability Calculator

13. Exit Strategies • Choose your risk level • Close the position when – • Options expire • You get an early profit • Give back part of your credit, but nail the win • For example, a sure 5% return after 2 weeks might be better than risking a 6 week wait to get 10% • Consider keeping the long option for more profits • Loss equals credit (break even) • Net loss equals credit • The short option reaches its strike price (avoid assignment) • Use stops on the short option • If the trade looks like it might go bad, you can also – • “Roll up or down” by closing the position and opening a new position farther out, with a bigger credit • Open a spread in the opposite direction – Iron Condor

14. Options Analysis Software • Powerful tool • Chart likely trade results by date, IV, stock price, etc. • Get OptionsOracle • Free! Such software usually costs thousands • Download from http://www.samoasky.com/index.html • Include User Guide